What Is a Bond — and How Do They Work?
Not sure what a bond is or how it works? Learn everything you need to know about bonds and how these financial insurance work in our detailed guide.
The market allows you to invest in a wide range of financial instruments. While some of these are easy to understand, like stocks, and others are bundles of individual financial instruments, like exchange-traded funds or ETFs, others are a little more complex or opaque, especially to the average investor.
Today, let's explore what a bond is, how it works, and who might use bonds for investment or money-saving goals.
A bond is a simple, fixed-income financial instrument with the potential for a high yield — just not in the short term. It is a representation of a loan made by an investor to a borrower, usually a government agency/representative or corporate agent. A bond is a unit of debt — by unitizing that debt, companies or government agencies can then trade that debt like an asset such as a stock.
With a bond, a buyer purchases a chunk of debt from an issuer, acting like a lender. In exchange, the issuer pays a small interest fee regularly. At the end of the bond's lifespan, the issuer pays the debt back to the buyer in full. In this way, a bond buyer makes a small profit. In the meantime, the bond issuer has money to spend as needed.
You can think of a bond as a sort of "IOU" or "I owe you" loan between a lender and borrower. Each bond includes specific details for the loan, payments, due dates, etc.
Bond funds are frequently used by states, sovereign governments, companies, and municipalities to finance operations, projects, and other investments. Regardless, every bond owner is a debt holder or creditor for the initial bond issuer. Bonds can be bought on bond markets or secondary markets, which have their own market factors that affect interest rate risk, credit risk, reinvestment risk, and more.
Here's another example:
- A stock is a piece of a company. While you can't physically dig up or separate a piece of a company that exists across many stores and locations, you can own a piece of that company since it is represented by stocks. For instance, if a company has 500 shares and you own one stock, you own 1/500 of the company
- Similarly, a bond is a piece of debt. You can't "own" debt the way you can own physical assets like gold or silver. But if you own a bond, you own debt, similarly to how you "own" a stock or a metaphorical piece of a company.
All bonds have "maturity dates." At this point, the principal amount for a bond has to be paid back in full or risk defaulting on the original loan.
Why Use Bonds?
So, if bonds are essentially loans or chunks of debt, why buy them? Creditors purchase bonds because they know that the entity issuing the bonds, such as the US government, is good for them and will pay them back, plus interest increases the rate of return later.
The US government, for instance, is widely regarded as the most trustworthy borrowing entity on the planet. If the US government borrows money from you with a treasury bond, you can rest assured it will pay it back. Essentially, the government's credit rating is always high.
Thus, a savvy creditor might purchase bonds from the US government with peace of mind, knowing they will make a profit on those bonds eventually.
Furthermore, because trust in bond issuers (like big corporations or governments) is so high, bonds themselves can be traded between entities. You might buy a bond, for instance, for $500 knowing that the US government will pay you back that $500 plus interest in two years. Since this certainty is so high, you can sell that bond for $500 to someone else and make a profit.
Major Characteristics of Bonds
Every bond issued by a major entity will include some core characteristics. These characteristics include:
- Face value or par value. This is the money that an investment-grade bond is worth at the bond's maturity (i.e., when the loan is due in full). The face value is also what a bond issuer will use when calculating or determining interest payments. For instance, imagine that an investor buys a bond at a premium price of $1050, then another investor purchases the same bond at a later date for $950. When the bond matures, both of the investors receive the original $1000 face value for the bond
- The coupon rate is the interest rate the bond issuer has to pay based on the face value of the bond. This is always expressed as a percentage. Say that a bond has a 5% coupon rate. All bondholders or buyers then get 5% x $1000 (the face value). This equals $50 per year
- Coupon dates are the dates when the bond issuer has to make interest payments at a higher interest rate. This is usually semiannually, but payments can be made at any interval
- The maturity date is when the bond matures and the bond issuer has to pay the face value for the bond
- The issue price is the price the bond issuer sells the new bond for initially
Major Categories of Bonds
There are four major types of bonds you can purchase or sell:
- Corporate bonds, which are issued by companies
- Municipal bonds, which are offered by municipalities and states
- Government bonds and treasury bills, which are issued by federal government agencies like the US treasury
- Agency bonds, which are issued by big, government-affiliated organizations like Fannie Mae and Freddie Mac
Bond Ratings for Investors
Investors can purchase a wide variety of bonds as well. These bonds can come from the above four categories or issuers. Bond varieties include:
- Z-bonds or zero coupon bonds, which don't pay coupon payments. Instead, they are issued at a discount and generate returns on their maturity dates
- Convertible bonds, which are bonds with embedded options that let bondholders convert any debt into stock or equity at a particular point
- Callable bonds, which have embedded options as well. However, these callable bonds can be called back by a company before the maturity date if necessary
- Puttable bonds, which let bondholders put or sell a bond back to the company before the maturity date
Where Do Bonds Come From?
Typically, bonds are units of debt used by governments at all levels and sizes as well as corporations. They use bonds to borrow money. Governments and corporations are the primary issuers of bonds, but investment bankers may issue them as well depending on their needs and liquid capital.
For instance, a government may need to raise funds in order to build new roads or infrastructure for its citizens. To do this, it issues bonds to borrowers or creditors based on creditworthiness. The creditors purchase the bonds, knowing that the government will pay them back with interest later down the road.
Corporations may issue bonds to creditors in order to grow their businesses and raise funds through interest rate changes throughout the life of the bonds. Corporations may need to purchase equipment, hire employees, or build new infrastructure as well.
Regardless, bonds always come from the need to raise money. They let individual investors assume lending roles, as well as allow debt to be traded like a public asset. On a broad scale, bonds facilitate the exchange of money and help the economy operate smoothly.
Without bonds, the government would have difficulty raising massive funds during wartime or emergencies. Similarly, big corporations would have the faculty expanding or scaling without major support from traditional investors.
How Do Bonds Work?
Let's dig a little deeper into how bonds work.
Because of their natures, bonds are oftentimes referred to as "fixed-income securities." They are one of the primary asset classes that individual investors learn to use, similar to stocks (also called equities) and cash equivalents of stocks.
According to rating agencies, bonds work in situations like this:
- An entity, like the US government, needs to raise money to finance something, like a new project, raising an army, etc.
- The issuer or borrower issues a bond that includes all the relevant details, like interest payments, loan terms, etc. All bonds have a final date at which the loan must be paid back, called the maturity date
- The issuer sets the price for the bond. Bond prices are usually set "at par," meaning they are set at a rate of $1000 face value per individual bond. Note that bond prices can vary depending on other market factors as well
- The issuer then sells the bond to a willing buyer. The buyer can then sell the bond to someone else if they so choose. In this way, initial bond investors/buyers don't have to hold the bonds until the maturity dates
- In addition, a bond issuer, like the US government, can repurchase bonds from borrowers. Bond issuers may do this if interest rates decline unexpectedly or if their credit improves, for example
Advantages of Buying Bonds
There are several advantages to buying bonds as an individual investor.
- Bonds are safe compared to other assets. For example, if you have most of your portfolio invested in higher-risk assets with higher yields, like stocks, adding some bonds will both diversify your assets and lower your portfolio's risk overall. Diversification via bonds is one of the best ways to make money consistently
- Bonds represent a type of low but fixed income. Since bonds always pay their interest at regular and predictable rates, you can count on that income in your bank account at set times
- You can get all of your principal back if you hold a bond to maturity
- You can also make a major profit if you resell a bond at a higher price than when it was issued
Disadvantages of Buying Bonds
However, buying bonds does have some potential disadvantages as well.
- Compared to other assets on the stock market and in mutual funds, bonds paid out lower returns or dividends due to lower interest rates
- Companies may default on your bonds, rendering them essentially worthless. These so-called junk bonds may lead to no bond yield (repayment) whatsoever
Essentially, long-term bonds are low-risk and low-yield investments. This doesn't necessarily mean they are only good for beginning investors, however.
Due to their stability and general reliability, bonds are important parts of portfolio stability. They can also serve as important investment assets for retirees or those who are looking to build up passive income rather than make major profits in short time frames.
Bonds are important fixed-income securities that every investor needs to know. They may make up an important part of your portfolio in the future, or they could represent a way for you to solidify your investments against market volatility. In any case, now you know how bonds work and whether you should pick up a few for your portfolio in the future.
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